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Is €48bn a lot or a little?

Europe’s banks misvalued their assets by €47.5bn. That is the verdict of the European Central Bank, after its examination of eurozone bank balance sheets. The scale and quality of the exercise has been impressive, and the market seems to like it. But is it just a big nothing?

Finding a €48bn loss is a big deal, you’d think. JP Morgan, a vast conglomerate with a self-described “fortress” balance sheet, had a wobble when it found a $6bn loss; the president of France intervened to try to steer BNP Paribas away from its $9bn fine.

But across the eurozone banking system, is a €47.5bn mistake such a big deal?

Firstly of course, the missing €47.5bn the ECB found was not, strictly speaking, a loss. It is the amount that eurozone banks need to change the value of their assets by. The banks’ assessment of asset value and the ECB’s assessment differ by €47.5bn, which certainly feels like a loss (given that the ECB is the new supervisor, prudent banks will have to have a very good reason not to carry assets at their value). The actual number coming through P&L will be closer to €33bn, thanks to tax effects.

For a little perspective, the total balance sheet size the ECB assessed was €22tr (the risk-weighted balance sheet was a little under €11.2tr).

So the misstatement was either 0.2% or 0.4%, depending how you look at it. Individual countries did worse – Greece, Cyprus and Slovenia ranged from 2% to 3.5% — but any system which can value a €22tr bundle of messy financial contracts with cashflows stretching decades into the future within 0.4% of what it is supposed to should probably be congratulated.

Look closer

But it only gets truly terrifying when you look at it by portfolio and asset class. The ECB did not randomly sample portfolios or credit files when it did the review. Instead, it focused on more challenging portfolios where it expected a greater degree of deviation or judgement had been applied.

Simply applying the ECB's rules about whether a loan counted as non-performing added 15% to the number of non-performing large corporate exposures, 7.3% to shipping and 5.5% to project finance. After a detailed review of individual loan files, the number of non-performing loans according to the ECB jumped 33.3% for large corporates, 35.8% in shipping and 31.2% in project finance.

Individual jurisdictions also deserve a place in the rogues’ gallery — 32% of the loans at Slovenian banks that the ECB examined in detail needed recategorising as non-performing.

These numbers — an extra €136bn of non-performing loans — were behind most of the €47.5bn misvaluation in assets, with a minor contribution from misvalued collateral and extra credit valuation adjustments for derivatives books.

Seen this way, the AQR has been scary, and perhaps will be cathartic. Investors now know how bad shipping loans are, and how far banks have been understating the problem, rather than having to guess. An extra €9.4bn of non-performing shipping loans is not pretty, but it is not systemic, and similarly, the €1.9bn of newly non-performing project finance will not cause upsets outside the division that books it.

But these results do not herald great things for the European economy. Shipping, large corporates and project finance are the realest of real economy lending — the necessary lubrication for a manufacturing economy, the stuff of glossy marketing campaigns from contrite state-owned lenders.

Banks had already pulled back from aggressive lending to these sectors, hence the protracted handwringing from the European Commission on how to encourage long term financing of the real economy. If lending to these borrowers was not appealing when wild mis-statement of the risks was tolerated, how much worse will conditions grow under the stern supervision of the ECB?

That is not an argument against transparency. It remains better for investors to know than to have to guess. But it does hint that reviving lending to certain sectors will be a long road back.

For retail SMEs though, as well as other retail lending (mainly consumer loans), the news is much better. The ECB only found another 4.2% of non-performing loans to retail SMEs, and 1.2% to other retail, despite deliberately targeting what it expected to be the worst portfolios. The sectors which ought to benefit from an ECB-inspired securitization market revival came out looking fine.

So the AQR adjustments will fall heavily on specific sectors. From far enough away, the AQR adjustments look laughably small — a slapped wrist for the most egregious offenders, a free pass for everyone else. But for shipping lenders and project financiers, the post-AQR landscape looks bleak. 

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